So did I call Rio Tinto (LSE: RIO) (NYSE: RIO.US) wrong last month? I said Rio Tinto is “now a pure play on China”, and with the world’s second-largest economy battling to contain a housing and credit bubble, investors should be cautious. Yet while the world frets about China, investors remain relaxed about Rio. Its share price is up 6% in the past month, easily outpacing the go-nowhere FTSE 100. Rio is on a roll, but can it continue?
There was good news last weekend, with press reports that Rio is a frontrunner to buy a stake in one of the world’s biggest iron ore deposits, the Simandou deposit in Guinea. It already owns half the concession, and chief executive Sam Walsh is eyeing up the rest. A recent reversal in the falling prices of metals, on hopes of Chinese stimulus, has also worked in the stock’s favour.
Chinese Stimulus Fails To Stimulate
The question is whether the Chinese authorities have enough fiscal firepower to re-tilt their economy, without blowing further bubbles. Markets remain hopeful, despite the disappointing mini-stimulus package unveiled earlier this month. Even if it does, China can’t keep gobbling up half the world’s supply of iron ore forever, as it continues its unsteady shift from an export to a consumption-led growth model. GDP growth in the first quarter fell to 7.3%, AFP has just revealed, putting China on course for its worst performance in 25 years.
For that reason, I am less bullish on the miners than most analysts. JP Morgan has just reduced its target price from 4600p to 4500p, but remains overweight. Deutsche Bank has lowered its target price 2p to 4640p, but still says buy. At today’s 3400p, that leaves plenty of upside.
These positive ratings are a vote on China as much as Rio. And it’s China that worries me, rather than Rio itself, about whom I have little complaints. I think Walsh has done a fine job since his appointment, rightly reversing his predecessor Tom Albanese’s costly acquisition and investment strategy, boosting profitability.
Iron In The Soul
In one respect, Rio is doing too well. It recently hit annual production records for iron ore, bauxite and thermal coal. The downside is that could weaken prices, especially if Chinese demand slows.
That said, the iron ore price has jumped 12% since hitting an 18-month low, to around $117 a tonne. Industry experts suggest it has had a strong floor of around $110. Beware the extra layer volatility, caused by stockpiling in China, which uses iron ore as collateral for trade credit and loans. Its stockpiles have jumped 40% in a year to a record 108 million tonnes.
In the longer run, Rio has further cost-cutting opportunities, as automated mining using remote control and robot-operating systems spread through the industry, cutting staff health and safety costs. You certainly aren’t overpaying at 10.3 times earnings, plus a 3.4% yield. I got one thing right. Rio is on a roll right now, but remember, China has loaded the dice.
